What Aave Users Should Know About Taxes

What is Aave?

AAVE is a DeFi protocol that allows users to lend, borrow, and earn interest on cryptocurrencies without the need for intermediaries like centralized exchanges. It offers several features, including flash loans, lending, borrowing, and collateral swaps.

Interacting with the AAVE protocol is done through smart contracts, it is one of the most well-known Ethereum-based DeFi platforms and is also deployed on Polygon, Avalanche, and other chains.

The platform provides the interest-bearing aTokens, designed to make it easier for users to access and move collateral on the platform. aTokens represent a portion of the underlying asset in a decentralized, non-custodial manner and can be used for lending, borrowing, or transferring value between Aave users.

What Can You Do in Aave?

Aave allows users to borrow and lend cryptocurrencies like Bitcoin, Ethereum, USD coin, Uniswap, and many more. If you lend, you earn interest. Conversely, in you borrow on Aave, you pay interest. Users who supply their crypto assets to the protocol and earn interest receive a corresponding amount of aTokens, which they can choose to trade or hold.

The protocol has gone through several iterations. The initial version, Aave V1, mainly focused on allowing users to lend and borrow a limited number of cryptocurrencies. Aave V2 was launched to provide a more robust and flexible user experience, allowing lending and borrowing an expanded range of cryptocurrencies. It also introduced new features such as the ability to switch between fixed and variable interest rates and flash loans, which are short-term loans that do not require collateral.

The latest, Aave V3, offers greater capital efficiencies, increased security, and cross-chain functionality with increased decentralization across the governance of the protocol. Some of the new features introduced include instant liquidity transactions, efficiency mode (eMode), isolation mode, siloed borrowing, and supply borrow caps. For more detailed information about Aave and its version differences, you can refer to their documentation.

Is There Any Risk While Using Aave?

While AAVE is considered a relatively safe platform for DeFi transactions, two sources of risk to consider when using Aave are liquidation risk and smart contract risk.

Liquidation risk relates to the scenario when the value of the crypto collateral you deposited falls below a certain threshold, and the system automatically sells the collateral to repay the crypto loan.

On the other hand, smart contract risk involves the potential for code vulnerabilities or exploits, which can lead to unexpected financial losses. It's important to keep these risks in mind when using Aave and to take appropriate precautions to mitigate them.

Overview of Aave Taxes

As DeFi gains traction among crypto holders owing to the capabilities it offers compared to traditional financial (TradFi) institutions, more people are using Aave for their lending and borrowing needs. However, if you realize a profit from these activities, there will be tax implications.

As you may know, the Internal Revenue Service (IRS) treats cryptocurrency as property. Any gains or losses from crypto assets must be reported on your tax return. When using Aave, there are several tax liability considerations, depending on the transaction type. Let’s look at the tax rules for common transactions involved in using the protocol.

Taxable Events on Aave

The IRS has not yet issued specific guidance on taxable events for AAVE or other DeFi protocols. However, it’s generally recommended to take a conservative approach based on prior IRS guidance pertaining to crypto assets. You should accurately calculate and report the gains, losses, and income from your Aave investing activity.

Certain activities when using Aave may trigger a taxable event. Some of these include:

- selling or exchanging aTokens for another cryptocurrency

- earning interest on aTokens

- executing flash loans.

Lending Cryptocurrency

When you lend funds on Aave, you receive aTokens in return, which represent your supplied assets in the liquidity pool. The interest earned on supplied funds is paid out in the form of additional aTokens.

The IRS has not issued specific guidance on the taxation of lending funds on the Aave protocol, so it's best to take a conservative approach based on prior guidance provided which suggests that lending crypto on Aave is subject to taxation because in return for providing funds you get aTokens in a 1 to 1 proportion, meaning that it can be seen as a crypto to crypto trade.

Flashloans

The AAVE protocol offers a feature called flash loans that is intended for developers. It basically enables you to borrow any quantity of assets for a brief period of time (typically a single block transaction) without having to provide any collateral. The catch is that the flash loan can be correctly executed only if the liquidity is returned to the protocol; otherwise the transaction will be reverted. In the absence of a specific IRS guidance on the taxation of flash loans, keep in mind that any profit generated through this feature is subject to CGT.

Receiving Lending Rewards

A conventional approach to the taxation of will dictate that these transactions incur a taxable event. First, when a lender receives tokens as an incentive for providing funds, the value of these tokens is generally categorized as income and is subject to income tax at the fair market value (FMV) when received. Moreover, if the lender sells or exchanges these tokens later, they may owe capital gains tax on the difference between the value of the tokens when received and sold.

Staking Rewards

Staking is a way to earn rewards on your assets by locking them up for a period of time. The US tax authority has not issued specific guidance on how to tax staking rewards from AAVE or other DeFi protocols. Based on prior instruction issued for rewards form activities such as mining or airdrops, it's better to take a conservative approach and establish that staking rewards are taxable income, based on the fair market value at the time of receipt.

For example, if you stake 100 AAVE tokens and receive additional 10 aTokens in rewards, the value of those rewards will be taxed as income at the time of receipt. Keep in mind that if you later trade your reward tokens, you'll need to pay capital gains taxes on any profits you make.

Borrowing Funds

The IRS has not issued any specific guidance on how to tax borrowing transactions from AAVE or other DeFi protocols. To understand this better, let's take a look at the transaction flow when borrowing assets on Aave. First, you need to supply some assets before borrowing, this transaction will incur a taxable because you will be receiving aTokens in exchange for the supplied assets.

By taking out a collateralized crypto loan, you retain ownership of the assets you used as collateral. However, you lose the ability to trade them during the repayment period. In case you have to exchange cryptocurrency to repay the loan, this conversion may be taxable as it represents a crypto-to-crypto trade, meaning that is subject to capital gains.

Moreover, if the value of your collateral falls below the accepted risk level, your position may be liquidated. This means that AAVE will sell your collateral to repay your crypto loan. When your collateral is seized, you don’t lose it for $0. Instead, it is used to repay liquidity providers the amount that you owe based on its fair market value at the time the liquidation occurs.

Since your loan is repaid, you no longer owe anything to the lender. Because of the cancellation of debt (COD) income, however, you could actually record a gain from the liquidation, since you still control the borrowed assets which would be taxed as COD income. This is a grey topic on crypto taxation and may be subject to special tax rules, so it is advisable to always consult with a tax advisor based on your specific situation.

Swapping Tokens

When you swap assets, you are essentially selling one crypto asset and buying another. This means that you may have to pay capital gains taxes on any profits you make. The amount of capital gains taxes you owe will depend on the length of time you held the token you sold and the profit realized. If you held the token for less than a year, you will be taxed at the short-term capital gains rate, meanwhile, the long-term capital gains rate will apply if it's held for more than a year.

Non-Taxable Events

There are several non-taxable transactions that you should be aware of as Aave user.

Voting on proposals

Using Aave tokens to vote on proposals does not involve the sale or exchange of cryptocurrency. The action has no immediate financial gain or loss and is thus a non-taxable activity.

For example, if you own shares in a company, you would not have to pay tax on the value of your shares simply because you voted on a proposal at the company's annual meeting. The same principle applies in the crypto space. When you vote on a proposal, you're simply exercising your right as a token holder to have a say in how the protocol is governed.

Transaction Fees

Transaction fees are incurred when you move funds in and out of your Aave account – such as transferring funds to a different wallet or withdrawing funds to a bank account. These fees are necessary for the normal operation of the platform. The IRS has not issued specific guidance on whether paying gas fees represents a taxable event. However, they may impact the cost basis, so you must properly track and report them.

Internal transactions

Internal transactions on Aave are not taxable because they don't involve any kind of asset swap. These types of transactions occur when users move their funds from one Aave account to another for lending and borrowing purposes. The funds remain under the control of the user at all times, and no third-party is involved in the exchange. As a result, these internal transfers are not subject to tax.

How to File Taxes on my Aave Transactions?

To calculate your taxes, you will need to determine your cost basis and income. Your cost basis is the price you paid for the cryptocurrency, plus any fees associated with the purchase. Your income is the fair market value of the cryptocurrency when you earned it, such as through mining or staking. You must report all of your cryptocurrency transactions on your tax return. You can use Form 8949 and Schedule D to report your capital gains and losses from your crypto activity on Aave.

Calculating Crypto Taxes for Aave Transactions

Calculating crypto taxes for Aave transactions can be complex and time-consuming, but it is necessary to ensure compliance with IRS guidelines. The tax implications of using Aave include capital gains taxes on profits from crypto trades, as well as income tax on interest earned from lending or staking transactions.

When calculating crypto taxes for transactions on Aave and other DeFi protocols, it’s essential to understand how the cost basis for each transaction is determined. The cost basis is essentially the price of a crypto asset at the point when you first acquired it. To determine the cost basis accurately, you need to take into account the date, any fees you paid, and the value of the asset in US dollars. Handling these calculations properly ensures that your taxable gains are accurately reflected and documented for tax purposes.

If you still have doubts about how the tax treatment of crypto assets in the US, check out our regularly updated 2023 US crypto tax guide written by tax experts.

Does Aave Report to the IRS?

No, Aave does not report to the IRS. As a decentralized protocol, it doesn't have the capacity to collect or report user data to the IRS. However, US taxpayers are still responsible for reporting all taxable Aave transactions on their annual tax return.

How Can a Crypto Tax Calculator Help With Aave Taxes?

Using a reliable crypto tax calculator can simplify the process of reporting your Aave transactions. When using Accointing, for instance, all you need to do is connect your wallets to the crypto tax platform. The tool then automatically calculates the cost basis and capital gains/losses from your lending and borrowing transactions for the wallets you imported. With multiple integration methods available, users can generate a tax report fast, in a few simple steps. The platform allows you to identify unknown currencies, internal transactions, missing funds, and solve unclassified transactions issues.

Main Takeaways

• Aave is a DeFi protocol that allows users to borrow and lend cryptocurrency. When using Aave, it's important to understand the tax implications of your transactions.
  
• With a crypto tax software, you can report your transactions accurately and continue interacting with DeFi protocols while staying compliant. Don't let taxes prevent you from taking advantage of everything Aave has to offer

The information contained in this guide, including any supplemental materials, is for general information purposes and does not constitute financial, investment, legal, or tax advice. The present content is not intended as a thorough, in-depth analysis, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. Please consult your tax advisor.